China’s financial system ‘vulnerable’

China’s financial system is at risk from bad loans, booming private lending and sharp falls in property prices, the International Monetary Fund warned today, as it called for sweeping reforms.

In its first formal evaluation of China’s financial system, the Washington-based lender blamed “heavy” government involvement in the country’s banks and watchdogs for reducing market discipline and corporate governance.

The fund also called on Beijing to relax its control of the yuan currency and allow the central bank more freedom over policy decisions.

Rampant lending since the 2008 financial crisis has left many companies and local governments in China with huge debts, while a recent slowdown in economic growth and falling property prices have fuelled fears of an explosion in defaults.

While China’s financial sector was “robust overall”, inefficient credit allocation and other weaknesses needed to be addressed, said Jonathan Fiechter, deputy director of the IMF Monetary and Capital Markets Department.

“While the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and the formation of bubbles, especially in real estate,” said Fiechter.

China is one of 25 “systemically important countries” that has agreed to mandatory evaluations at least once every five years, the IMF said, though Beijing has no obligation to implement the recommended reforms.

However, it added that a full assessment of the risks was hampered by “data gaps”, limited information and restrictions on access to confidential figures, the IMF said.

The central bank said the IMF report made “objective and positive” overall assessments but some of the recommendations required “in-depth study”, taking into account China’s situation.

In a list of 29 key recommendations on how Beijing could improve its financial system the IMF urged policymakers to allow state-owned banks to make lending decisions based on commercial risk rather than government policy.

It also called on Beijing to allow interest rates to be determined by “supply and demand”, and to use this tool rather than administrative measures to control credit.

The People’s Bank of China has raised interest rates five times since October last year but it has been reluctant to hike rates too aggressively for fear of triggering defaults.

China has instead relied on several increases in the reserve requirement ratio – the portion of deposits banks must set aside – to curb lending which Fiechter told reporters was a “pretty crude tool that may promote shadow banking”.

Local government debt has ballooned since Beijing ordered banks to boost lending to combat the 2008 global crisis, with official estimates putting the borrowings at 10.7 trillion yuan (about R13.5 trillion) at the end of last year – or about 27% of China’s 2010 gross domestic product.

But in the past 12 months, as authorities tried to stem the flow of credit to curb surging inflation and property prices, underground lending flourished and is worth an estimated four trillion yuan.

Fiechter played down the chances of the government reopening “the floodgates” for lending to cushion the impact of the eurozone debt crisis, saying he did not believe it posed “that much risk to economic growth”.

The IMF also called on authorities to loosen currency controls and give autonomy to the central bank and other supervisory bodies to “help bring the system more in line with international practices”.

Despite numerous vulnerabilities in the system, the IMF said stress tests of China’s 17 largest banks found most of them would be resilient to “isolated shocks”.

But a confluence of events such as a slump in property prices – which have already started to fall nationwide – changes in the exchange rate and a sharp slowdown in economic growth could “severely” impact the sector, it warned.

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